Tracing Steel's Fiery Ascent -- Part II

Over all, we like the growth prospects for the industry. Everyone is throwing off huge cash flow. Debt's being paid down and pensions are being fully funded. But the opportunities for capital redeployment and the skill sets for the redeployment vary tremendously. Two stocks at the top of my list are
Reliance Steel & Aluminum
[RS] and Nucor. Both are growth companies masquerading in cyclical clothing. Both have grown their top lines about 20% since 2000. Both have grown their bottom lines significantly more than that. If you hold the debt constant for the next five years, you could easily see both companies funding growth in the 10% to 12% range totally from internal cash flow and earnings per share of a similar amount. Nucor has had a compound average growth rate in excess of 20% every year since 2000. They have just announced a huge acquisition of Harris Steel, which is not a steel company but a buyer and fabricator of steel. It is exciting because it is a different kind of acquisition for Nucor. The company in the past has been reluctant to expand into its customers' business. It's also paid a healthy multiple for Harris. It was over six times cash flow, which might not seem a rich multiple but is compared to the pennies on the dollar acquisitions that they've done historically.

Is this the start of a trend?

I expect to see more growth in the downstream side of the business: metal bending and fabricating and metal buildings. Just take rebar fabrication. The three largest players in that business are roughly 35% of that market. It is a very fragmented market. So there are a lot of opportunities for other significant acquisitions, and that is just one market. Metal buildings would be another; pipe would be another. Distribution, potentially another. Nucor has a unique niche that should allow it to grow through acquisitions.

And the case for Reliance?

Reliance is a steel distributor. They also provide logistics. Reliance grows through acquisitions, and they acquire well-run private companies. They went public in 1994 with just under a half-billion dollars in sales, and this year their sales are projected to reach $7 billion. They've made 40 acquisitions since 1994. They are more profitable than other distributors, and I need to make my spreadsheet columns wider for them because they have double-digit margins and nobody else does.

Their guidance was pretty subdued for the next quarter. But when you sit down and map the universe and say, OK, they've got $7 billion in sales, so how big is the distribution market and how much can they acquire? The total distribution market in the U.S. for all types of metals is $130 billion. The top dozen players are less than 50% of that. It is still a very fragmented market, with lots of opportunities for growth for a company like Reliance. There has also been talk the last two years about mills and service centers [which process steel and then resell it in a revised form] getting together and integrating.

What do you think of that?

I think there would be a lot of pluses. If you could align the two in some way, the industry would be a lot more efficient, more customer-friendly with less volatile pricing. However, to get from here to there might be difficult, because if a mill suddenly bought a service center, the other service-center customers would run away. While the long-run answer is a good one, getting there is difficult. Layer on that the situation with
Ryerson
[RYI], a competitor to Reliance, where the private-equity firm Harbert Management is stirring things up because Ryerson has not lived up to its potential for an awfully long time. The trade press also says
Arcelor Mittal Steel
[MT] is looking at Ryerson so there is an end game. If those two were to join up, it might make others consider a relationship. If you go back 25 years, most of the mills owned their distribution.

How is Reliance valued compared with its peers?

It is at seven times Ebitda [earnings before interest, taxes, depreciation and amortization], about average compared to the peer group. Both Nucor and Reliance are trading at a little over 10 times their '07 earnings estimates. Nucor is at two-thirds the market multiple with a demonstrated growth rate the last five years in the 20% range. It has no debt and pays out $1 billion a year to shareholders in dividends and buybacks, and yet the stock is at 10&frac12; times. We know that growth in steel-making assets is gone, there are none. The store is empty. What people don't understand is that the downstream growth at Nucor is sustainable at a reasonable price.

The market has to get a little smarter and understand what is unique about Nucor. And it is not only Nucor. Steel Dynamics has a lot of the same characteristics. It's cheaper on an enterprise value [market value plus net debt]-to-Ebitda basis but about the same on a multiple-of-earnings basis. It is also one of the lowest-cost producers.

Yes, steel companies that can grow: It's not a bizarre topic, it's a viable topic. There are growth stocks in this sector and they should get premium multiples for the growth. Maybe market multiples. But at 10 times, they are pretty far away from that.

Other companies obviously recognize the value.

What is disturbing is the increasing amount of European interest.

Why?

Because typically their return requirements are lower than ours, and it makes it a lot more difficult to compete if you are looking at the same assets. Having said that, there are still lots of strategic combinations that have not happened yet.

There are two primary global themes in M&A in the steel industry. One involves the BRICs, ex-China, or BRIs -- Brazil, Russia and India are very rich with raw materials and they traditionally have been focused on the upstream side of the business. But they now are looking for downstream processors of their raw materials. So some of these transactions, like Russia's
Evraz
[EVR.UK] buying Oregon Steel, India's
Tata Steel
[TATA.INDIA] buying Corus and
CSN
's [SID] unsuccessful attempt to buy
Wheeling-Pittsburgh
[WPSC], are about going downstream.

The other theme, which has been less prevalent but is going to get bigger, is about Europe and Japan looking for exposure to high-value-added markets. There is increasing pressure on the Japanese companies in particular to expand their participation in the U.S. I could see Japanese or European interest in a company like
AK Steel
[AKS]. What makes AK Steel unique is that they are the buyers of the semi-finished steel made in Russia, Brazil and India, and they have one of the best consumer-durable franchises in this country. While it would be a great fit for U.S. Steel, AK Steel's valuation is relatively rich for them. AK Steel would be worth more to a Japanese or European company, which would pay more to get into the automotive market in the U.S.

What about reports that Arcelor Mittal is interested?

The notion of a Mittal bid for AK Steel is not credible. Mittal already is the largest player in many of AK Steel's key markets, and there most probably would be anti-trust issues. Far more compelling, in our view, would be interest by
ThyssenKrupp
(TKA.GERMANY], CSN or any of the Japanese steelmakers that are increasingly looking to follow their automotive customers into the domestic market.

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